Question

Use relevant diagrams to answer the following: (Assume a closed economy unless stated otherwise)

c. If consumers foresee future taxes completely, what would be the impact of reduction in taxes this year that is accompanied by an offsetting increase in future taxes, on the goods market equilibrium. (Assumes that taxes don’t impact investment decisions and also assume consumption smoothing)

d. The tax code changes so that business firms face higher tax rates on their revenue (offset by other lump-sum tax changes so there's no overall change in tax revenue). What happens to saving, investment, real interest rate and current account balance in a small open economy.

Answer 1

1. Tax cuts boost demand by increasing disposable income. Households will choose to divide their income between savings and Consumption

2.. In the short run, a tax cut will increase output, but the effects on the trade balance, price level and total tax revenue are ambiguous. A reduced relative price between domestic and imported goods is a necessary condition for an improved trade balance, which in turn is a necessary condition for an increase in tax revenue. In the long run, the tax cut will have no output effect, while the real wage and the relative price between domestic and imported goods will rise and the trade balance will deteriorate. The price level will increase if the exchange rate is fixed, but is unaffected if the exchange rate is flexible.